For the second time in three years, the banking system has collapsed, which means that the banks are no longer able to fund themselves through the normal means, the wholesale markets. This same thing happened in July 2007 when two Bear Stearns hedge funds defaulted and trillions of dollars of mortgage-backed securities–which US banks had been holding–began to sharply decline in value. In a matter of months, most of America’s big-name banks were technically insolvent although the charade continued for a full year before Lehman Brothers blew up and the rot within the system became apparent to everyone. Now the same thing is taking place in Europe.

The banks do not get the bulk of their funding through their regulated activities of taking deposits and issuing loans, but by exchanging assets for short-term loans. Naturally, when doubts arise about the quality of these assets, then trading slows to a crawl and the banks are left high-and-dry. In other words, banking has transformed itself into an unregulated multi-trillion dollar pawn shop that can shut down at a moment’s notice leaving the entire industry dead-in-the-water.

When crisis strikes, alarms go off at the central banks who then ride to the rescue with lavish taxpayer-funded bailouts. We’ve seen this play many times before, the script never changes. The central bank chiefs claim that they are just offering liquidity assistance for “temporarily” impaired assets, but, of course, that’s not true. Two years after the Fed began its purchases of toxic MBS from US banks, all of those same assets are still on the Fed’s balance sheet. The Fed’s has become a “bad bank” where the stinkpile of unmarketable dreck the banks created via financial alchemy is housed. Eventually, the losses will be passed on to the taxpayers.

Imagine if the $350,000 home that you bought at the peak of the bubble in 2005 was suddenly “unsellable” at any price. This is the situation EU banks are in. No one wants to do business with them because there are doubts about their solvency as well as questions about the value of their assets. So, the system has shut down forcing the banks have to depend more and more on funding from the ECB. Of course, it doesn’t work this way for the average working guy. When the value of his house falls or his credit score gets slashed, he just has to suck-it-up and live on less because no one will give him a loan. It’s different for bankers.

EU Banking System: How bad is it?

Last week, the ECB lent 523 banks a total of 489 billion euros for three years at 1 percent. On Wednesday, those same banks parked all of the money they borrowed (except 37 billion euros) back at the ECB in overnight deposits. (That’s 452 euros, a new record) Think about that for a minute. In other words, the system is not just broken; it is completely broken. There’s no lending, no exchange of assets for short-term loans, no credit expansion, no nothing. Zilch. All there is is hoarding and a lot of PR gibberish about “emergency liquidity”, “long-term refinancing”, blah, blah, blah. The average Joe doesn’t want a bunch of excuses; they want the facts. And the fact is, this unregulated, volatile, crisis-prone system has collapsed for a second time in three years which is why the central banks are committing trillions (just look at the ECB’s exploding balance sheet) in public money to bailout speculators who’ve gamed the system. That’s all people want to know.

So what is the ECB trying to achieve by pumping all this money into the banking system?

First of all, ECB chief Mario Draghi is trying to reflate the bubble in the bond market. You see, during the boom years, capital flows into Greece, Portugal, Spain etc, boosted the value of the sovereign debt by many orders of magnitude. The main buyers of these bonds were EU banks, so they are loaded to the gills with this junk-paper. Since Greece started teetering, the value of these bonds has plunged leaving many of these banks in the red. And the situation is even worse than it sounds, because the banks have borrowed more money than the original value of the bonds themselves. In other words, they have posted this same collateral many times over greatly increasing their leverage and their exposure. It would be like if you or I took our prize racing bike down to the pawn shop and exchanged it for a short-term loan of $3,500. Only–in this case–the pawn shop owner allowed us to hold on to the bike. Then we went to another pawn shop, and a third and a forth; posting the same bike for the same short-term loan over and over again. Pretty soon, the debt is so huge, that any disruption in the flow of business, and the whole Ponzi-debt pyramid comes tumbling down. Presently, the ECB is trying to keep that pyramid in place by inflating the value of the dodgy bonds with injections of 3-year liquidity. These loans will never be repaid. Now take a look at this from the Wall Street Journal:

“Even after the European Central Bank doled out nearly half a trillion euros of loans to cash-strapped banks last week, fears about potential financial problems are still stalking the sector. One big reason: concerns about collateral.

The only way European banks can now convince anyone—institutional investors, fellow banks or the ECB—to lend them money is if they pledge high-quality assets as collateral.

Now some regulators and bankers are becoming nervous that some lenders’ supplies of such assets, which include European government bonds and investment-grade non-government debt, are running low.

If banks exhaust their stockpiles of assets that are eligible to serve as collateral, they potentially could encounter liquidity problems. That is what happened this fall to Franco-Belgian lender Dexia SA, which ran out of money and required a government bailout.” (“European Bank Worry: Collateral”, Wall Street Journal)

So, the banks don’t have money and they don’t have good collateral. And the reason they don’t have good collateral is because they’ve been posting the same collateral over and over again to increase leverage. So, it’s all a sham; they’re upside down and headed for trouble. Here’s more from the same article:

“In addition to fears that the banks might simply run out of eligible collateral, some bankers and regulators worry that the banks’ growing reliance on “secured lending” will make it harder for the industry to return to its past practice of funding itself by issuing unsecured bonds. That could result in a permanent funding scarcity…..

Since this summer, it has been virtually impossible for banks to issue unsecured bonds, because investors view European banks as risky investments.

In the second half of 2011, European banks issued a total of about $80 billion of senior unsecured bonds, according to data provider Dealogic. That compares to $240 billion in the same period last year and $257 billion in 2009.” (“European Bank Worry: Collateral”, Wall Street Journal)

Financial journalists love to make this stuff sound harder than it really is. Look, this is simple. No one is trading with the banks because everyone knows they’re broke. When the author says that the banks’ “growing reliance on “secured lending” will make it harder for the industry to return to its past practice of funding itself by issuing unsecured bonds”; what he means is that the banks funding-model is kaput, because the bonds the banks own are losing value and no sane person will accept them in exchange for cash-money. So, the banksters are out of luck; they have to take their begging bowl to the ECB for handouts. And that’s where we are right now.

So, what’s the bottom line? What do these new developments (Draghi’s $600B Long-Term Refinancing Operation) tell us about the condition of the EU banking system and the probability of another financial crisis?

That’s the question I asked a friend of mine who works in the credit markets. Here’s what he said:

“Ask yourself one question, what has materially changed relating to solvency issues for banks in Europe in general and solvency issues for European countries in particular?